Government Debt and Deficits

16.1 Facts and Definitions

The government, like a household, has to pay for things (expenditures G and interest on old loans i \times D ). It gets money from taxes T . If the government spends more than it collects in taxes, it has to borrow money. This borrowing is called the "annual budget deficit" (represented as \Delta D = (G + i \times D) - T ), and it adds to the government's total debt.

The primary budget deficit is a simpler way to look at how much the government spends on its programs (not counting interest payments) compared to what it gets in taxes ( G - T ). It shows if current taxes cover basic government services.

Canada's financial history shows periods of large deficits (spending more than collected) from the mid-1970s to early 1990s, followed by a time with extra money (a surplus) from 1998 to 2008. Major events like the 2009 recession and the 2020 COVID-19 pandemic led to huge increases in borrowing, with the 2020 deficit reaching about 18% of the country's total economic output (GDP).

16.2 Two Analytical Issues

Fiscal policy is simply how the government uses its spending and tax rules. Changes in the budget deficit happen because of the government's choices and how well the economy is doing.

When the economy slows down (real GDP drops), the government automatically collects less tax money and often pays out more (like unemployment benefits), so the budget deficit usually gets bigger. When the economy is strong, the deficit tends to shrink. Government fiscal policy sets the overall spending and tax rules, but the economy's ups and downs cause the deficit to change over time.

The structural budget deficit is what the deficit would be if the economy was running at its full potential ( Y^* ). This helps economists see how much of the deficit is due to the government's actual policy choices, rather than just the economy being slow or fast. If the economy is in a slump ( Y < Y^* ), the actual deficit will be bigger than the structural deficit. If the economy is booming ( Y > Y^* ), the actual deficit will be smaller.

16.3 The Effects of Government Debt and Deficits

When the government runs big budget deficits, it can crowd out or make it harder for private businesses to invest, which can slow down future economic growth. Having budget surpluses (extra money) can help businesses and boost the economy.

In closed economies (countries that don't trade much with others), lots of government borrowing means less money is available for everyone else to save and invest. This pushes up interest rates, making it more expensive for businesses to borrow and grow.

In open economies (countries that trade a lot), large government deficits can attract money from foreign investors. This can make the country's currency stronger, meaning its goods become more expensive for other countries to buy, which can reduce its exports.

Government debt means that future generations might have to pay for today's spending. However, if the borrowed money is used for things that benefit future generations (like new infrastructure), then the burden might not be as bad.

Too much government debt can make it difficult to manage the economy:

Monetary Policy: If people believe the government might print more money to pay its debts (which leads to inflation), prices and wages will likely rise. This makes it harder for the central bank to keep prices stable.
Fiscal Policy: A lot of debt limits the government's ability to spend money or cut taxes to help the economy during hard times (like a recession).

16.4 Formal Fiscal Rules

Trying to make the government budget perfectly balanced every single year is a bad idea. It would stop automatic economic stabilizers (like unemployment benefits during a recession), making economic ups and downs even worse.

A better approach is to aim for cyclically balanced budgets, meaning the budget should balance out over the entire economic cycle (surpluses in good times cover deficits in bad times). A flexible approach is generally better than very strict rules.

Most economists agree that maintaining a prudent debt-to-GDP ratio is important. This means the total government debt should not grow faster than the national economy (GDP), which